Israeli PM Benjamin Netanyahu has called on Palestinians to return to negotiations.(Reuters)

The UK has condemned Israel's announcement that it is to build a further 300 homes in a Jewish settlement in the occupied West Bank.

"The expansion of settlements makes it increasingly difficult for Israel's friends to defend it against accusations that it is not serious about peace," said Baroness Anelay after meeting Israeli Vice Prime Minister and Minister for Interior, Silvan Shalom, in London Thursday.

Israel announced its plan to build the homes on Wednesday as it demolished two apartment blocks in the area following a court ruling by the country's Supreme Court.

"The [new buildings] are illegal under international law," the UK Foreign Office Minister of State said. "I was clear with Vice Prime Minister Shalom that the UK condemns the Israeli Government's decision of 29 July to progress 500 units in East Jerusalem and approve 300 further units in Beit El.

"Every settlement announcement has a negative impact on prospects for peace and a negotiated solution," she added.

Jewish settlers fought with border police who used water cannons during Thursday's demolition of the vacant apartment blocks.

Meanwhile, settlers are suspected of a 'price-tag' arson attack in a Palestinian village of Duma in the West Bank that burned toddler Ali Saad Dawabsheh to death.

Graffiti found on the walls of burned Palestinian homes in the village read "Long live the Messiah", "revenge" and "price tag".

Palestinian chief negotiator Saeb Erekat called the death "a direct consequence of decades of impunity" given by the Israeli government to extremist settlers".